RV Capital 2014 Investor Letter
Content
Business Owner TGV vs. the DAX
Year
2008 (3 months)
2009
2010
2011
2012
2013
2014
Compounded Annual Gain 2008 - 2014
Overall Gain Sep 2008 – 2014
Annual % Change
in Business Owner
(1)
-13.4%
31.1%
27.0%
6.5%
18.4%
31.9%
24.9%
19.2%
199.6%
Annual % Change
in the DAX
(2)
-17.5%
23.8%
16.1%
-14.7%
29.1%
25.5%
2.7%
8.7%
68.2%
Relative Results
(1-2)
4.1%
7.3%
10.9%
21.2%
-10.7%
6.4%
22.2%
10.5%
131.4%
A Great Year
Dear Co-Investor,
The NAV of Business Owner was EUR 299.61 as of 30 December 2014. The increase in
NAV was 24.9% since the start of the year and 199.6% since inception on 30 September
2008. The Dax was up 2.7% and 68.2% respectively.
The best way to track the development of the fund is to follow the earnings performance
of the underlying investments, not the year-to-year change in the fund price. I will report
on how our companies got on in my half-yearly letter.
New investors can expect a rigorous and dispassionate interrogation of the companies’
performance. More seasoned investors can expect a one-sided laudation with all the
balance of an Oscar nomination viewed through rose tinted spectacles. What can I say? I
am an unapologetic fan of our companies.
One new investment
In the second half, I added one new company to the portfolio: the US-based Credit
Acceptance Corporation (“CAC”).
I am frequently asked how I come across new ideas. One way is through a network of
like-minded investors. In this particular case, Matthias Riechert, an emerging manager
based in London, pointed out CAC to me. Thank you, Matthias.
When I invest in a company, I like to be able to explain it to my children in a single
sentence. In this case, a single sentence might read: “CAC provides financing to
subprime borrowers for the purchase of a used car”. Whilst true, this does nothing to
capture the magic of the business.
So, in several sentences, where is the magic?
CAC does many things differently than traditional lenders. Most importantly in my view, it
requires the car dealer to participate in the risk of the consumer loan. Upon sale of the
car to the consumer, the dealer receives an upfront payment from CAC. Including the
down payment from the customer, the dealer earns a modest profit at the time the loan
is originated. CAC splits the collections on the loan with the dealer with the dealer’s share
of the collections first used to repay the amount received from CAC at loan origination.
After this amount has been repaid to CAC, the dealer continues to receive his share of
the collections which is called “dealer holdback”. As a result, to maximize the dealer’s
profit, the consumer must repay the loan.
1
At first glance, it makes little sense to require the dealer to co-underwrite a loan. How
can he know if a consumer is a good risk or not? However on closer inspection, it subtly
changes incentives. In so doing, it sets off a wonderful win-win situation for all three
parties concerned: the consumer, the dealer, and CAC.
The three main reasons a subprime borrower defaults on a loan are a) he cannot afford
it, b) the car breaks down (in which case he cannot get to work), or c) he loses his job.
The latter – unemployment – correlates closely with the economy and is beyond anyone’s
control. However, the dealer can influence the first two: by putting the consumer in a car
he can afford and by making sure the car is not a lemon.
Notice how this inverts the traditional role of the used car salesperson: to persuade the
consumer to trade up to something fancier and to get rid of his lowest quality inventory.
The approach creates a win for the customer as she gets a decent car she can afford, a
win for the dealer as he is able to make a sale he might otherwise miss out on, and a win
for CAC as it is able to generate profitable business with a customer other lenders are
unable to address economically.
There is also a win for CAC which goes beyond the purely financial. CAC is a purposedriven company. Don Foss, the Company’s founder, set up CAC based on his belief that
many people who need a car, but do not have access to traditional financing, deserve a
second chance. By extending financing to them, CAC gives them a chance to purchase a
car and rebuild their credit score by making timely payments. The Company’s motto is
“We change lives”.
Four criteria
How does CAC stack up against my four investment critiera: a business which will be
around and flourishing ten or more years; possesses competitive advantage; has a
management with integrity and talent; and an attractive price.
Credit Acceptance should be writing business 10 or more years from now
Demand for cars will remain strong across the US. There is a tendency in Europe to think
of the car as a luxury purchase as public transport represents a perfectly feasible
alternative. In the US, by contrast, the car is closer to a utility as outside of the major
cities it is simply impossible to fulfil the most basic needs without one. Given the
increasing polarisation of incomes, there is every reason to believe the subprime
segment (sadly) will outgrow the overall market.
Most importantly, CAC has the capital strength and the underwriting skill to ride the
various down cycles. It had an equity ratio of 31% at the end of 2013, which is multiples
of its competitors’. It also has a unique ability to underwrite risk. In each of the last 10
years (including the great recession), actual collections have generally been higher than
forecast collections and the worst result was a 3%-point negative variance (for the 2001
and 2007 vintages).
In an industry characterised by boom and bust cycles, CAC should be around and
flourishing in the long term.
CAC has a unique business model
Auto finance is not a business characterised by barriers to entry. Used car dealers are not
the most loyal bunch and will switch in a heartbeat to the highest bidder for one of its
loans. As such, CAC does not profit from barriers to entry in the classic sense. It does
profit from what Don Foss characterises as “barriers to success” or what I would term
competitive advantage. So what are its competitive advantages?
2
First, it has a unique expertise in underwriting and collections. This comes from many
sources, but in my view it benefits in particular from having been in the business far
longer than anyone else. This gives it the opportunity to continually refine its processes. I
visited the collections department and it is an impressive setup. Other more leveraged
players get wiped out at the end of each cycle leaving the way for a new crop of lenders
at the beginning of the next.
Second, it has a different approach to the market than most competitors. A big feature of
this is dealer participation in both the upside and the downside of its loans. As such, it
nurtures a partnership with the dealers rather than the typical customer/supplier
relationship between dealers and traditional lenders. Dealers self select who are keen
treat their customers fairly and change lives for the better. Those with a different agenda
leave the program as it does not work for them or do not start it in the first place.
CAC’s approach is difficult to replicate. It is nearly impossible for existing lenders to turn
their business models upside down. For new entrants, it takes a lot of time to build the
sales force, sign up and educate the dealers as well as develop the various other
processes and behaviours necessary to be successful.
Third, CAC has a unique culture, which is built around capital discipline and having fun.
CAC has no problem turning down unprofitable business. When it has surplus capital (as
is the case now) it simply redirects it towards buying back its own stock. There is no
pressure to write business. To get a sense of the culture, check out the video from its
40th birthday bash: https://www.youtube.com/watch?v=eZtWHGjfLYU. I had the good
fortune to visit the company on its birthday last year. It was great fun chomping on
hotdogs to Pharrell William’s “Happy”.
Management is talented and honest
There is a consensus amongst investors that it is tough to discern management quality.
Managers who reach the CEO position are necessarily great at selling themselves, they
contend, otherwise they would not reach their position in the first place.
For the most part, I agree. However, there is a small subset of managers it is not only
possible to evaluate; I would contend it is easy.
Don Foss, the Company’s founder, and Brett Roberts, its CEO, and several other of the
executives I met through my research process are part of that subset in my view.
Crucially, they have all been with the company for a very long time – in the case of Don
since the beginning in 1972 and in the case of Brett since 1991 (as CEO since 2002). One
can see how they reacted to crises (in the 1990s and more recently in the late 2000s),
whether they have communicated in an open and honest way with shareholders, and
whether they have delivered consistently outstanding results. On all these points, their
performance has been exemplary.
A case in point is a dispute between CAC and its auditor, as a result of which the 2005
annual report was delayed by nearly a year and the historical financials had to be
restated. When the new figures were published, it turned out CAC had understated
earnings over the previous 5 years by US$ 16.9 m. That is my kind of restatement!
To hear from Don Foss directly, watch this:
https://www.youtube.com/watch?v=wah9p824nYg.
3
Valuation is attractive
At the time of purchase, CAC was trading at around 10x my estimate of 2014 EPS. This is
for sure a below average valuation for an above average business.
What should the long-term holder expect?
The company is highly opportunistic in allocating its capital. When pricing is attractive, as
was the case after the financial crisis, it aggressively expands its loan book. This leads to
returns in the high 20s / low 30s, assuming 100% capital retention and a return on
equity of around 30%. When pricing is less attractive, as is the case now, it aggressively
returns capital to shareholders. Last year, it repurchased 2.5 m shares, equal to just over
10% of its market capitalisation. As it bought the shares back below intrinsic value in my
view, the actual return to remaining shareholders was slightly higher.
Overall, it does not seem impossible that the annual return to the long-term holder
varies between 10% and 30% across the cycle.
Why is CAC so cheap?
Leaving aside the very real possibility that my analysis is faulty, there are at least three
potential reasons.
Firstly, CAC makes no effort to court investors. It does not attend capital market events
or undertake investor road shows. Management is focussed on the business and not
marketing to investors. As a major purchaser of its own shares, it has no interest in
inflating the share price. This does not mean though that it is indifferent to its investors.
Doug Busk and Jeff Soutar, who in addition to their day jobs get to field calls from
investors like myself, took considerable time over many calls to explain their business to
me with courtesy, intelligence and patience. I am hugely grateful to them both.
Second, CAC’s business is cyclical which makes it more difficult to value than, for
example, Novo Nordisk. It faces at least two cycles: the economic cycle and the capital
cycle. The economic cycle impacts earnings as default rates rise in a downturn and fall in
an upturn. The capital cycle impacts earnings as pricing pressure increases when there is
too much capital around and decreases when the reverse is the case. To a certain extent,
the two cycles offset each other as when the economy is in the doldrums, capital tends to
be scarce, whereas when it is up, capital becomes more abundant.
This begs the question, where are we now in the cycle? The answer is probably in a
sweet spot. CAC still benefits from loans originated when pricing was higher whilst
default rates are most likely lower than initially expected given the improvement in the
economy. Analysts argue that earnings may come under pressure in the short term. They
are probably right. My mission though is to put our capital into companies which will be
significantly more valuable in ten years’ time, not gamble on quarterly earnings
surprises.
Third, there are concerns about potential regulatory interventions in the subprime space.
There are two main regulatory concerns: one is that a bubble is forming, risking a rerun
of the financial crisis, this time in car loans instead of housing loans. The other is that
subprime lenders are exploiting their customers. The former implies that pricing is too
low, whilst the latter implies it is too high. If both sides claim they are right, it will be
entertaining to see what the policy response is.
In my opinion, market pricing is frothy, i.e. too low from the perspective of the lenders.
That being the case, the market should right any imbalances over time. Should however
the regulator decide to sharpen industry standards, I would expect CAC to be a net
4
beneficiary given the obvious benefits of its lending model to all parties, not least the
borrower.
Isn’t subprime risky?
I can imagine some of you had a sinking feeling upon reading the word “subprime”. For
many it is synonymous with irresponsible lending, overpaid bankers, and the financial
crisis. For this reason, I want to make a few general comments on subprime lending and
why I am in favour of it.
To the casual observer, the root cause of the financial crisis was lending to subprime
borrowers. This was not the case.
The root cause of the financial crisis was irresponsible lending to subprime borrowers.
To understand this point, here is some background: The idea took hold in the early
2000s that pools of loans which individually were low credit grade could collectively
become “AAA” through the magic of diversification. The chimera of a higher interest rate
without any risk proved intoxicating to investors the world over. Demand exploded, in
particular amongst highly leveraged financial institutions, which were not allowed to hold
“risky” assets, such as the shares of great companies.
To meet the growing demand, bankers and brokers were helpfully on hand to whip up
demand for loans. Many individuals gladly bought houses (or second houses) that in
hindsight (and probably with foresight) they could not afford. As the bubble inflated,
underwriting standards, i.e. the conditions necessary for a loan to be approved, slipped.
This led ultimately to “no doc” loans, where the borrower was not required to
substantiate what his or her purported assets and income were. They were also known as
“liar loans” for reasons I cannot possibly imagine. Needless to say, it all ended badly.
It is important to note that the problem was not subprime borrowers per se but
deteriorating underwriting standards, primarily in the housing market. Warren Buffett
has made the point that in the manufactured housing market (in which there was no
credit bubble), loans performed no worse than would be expected in a recession despite
the typical borrower being subprime. For that matter, the same is true for subprime auto
finance loans.
It would thus be morally wrong to restrict the flow of credit to the poorest sections of
society.
It would also be financially wrong. For companies with good underwriting ability,
subprime is by far the most profitable market segment as there is greater variance in
credit performance. A first class lender to prime borrowers will struggle to differentiate
itself from peers as most borrowers repay anyway. In subprime, the divergence can be
enormous given a) the higher number of defaults and b) negative selection (the belowaverage underwriter fishes in a pool of loans the above average underwriters decline).
Does CAC exploit the financial illiteracy of its customers?
One question I also asked myself prior to investing is whether consumers are paying an
indecent interest rate. I have no interest in investing in a payday lender which charges
1% per day, which leads to a mind boggling compounded annual rate.
It is not obvious what the average interest rate on a CAC’s consumer loans are. The
nominal rate is generally 20 – 22% APR. However, both the dealer and the consumer will
generally focus on the monthly payment, which is a function of the sale price of the car,
the number of monthly payments and the interest rate. The dealer I visited said that he
generally leaves the interest rate untouched, but moves the sales price down to get a
5
deal that “works,” i.e. which the consumer can afford. As such, the nominal interest rate
perhaps overstates the economic one. Either way, for the lowest quality credits an
interest rate of around 20% seems high but not unreasonable.
A beautiful business
I started my discussion on CAC by describing it as having magic. I would like to finish on
that note. I can imagine a botanist walking through a rainforest would not be drawn to
the most conventionally beautiful creature, but the one with the most unusual adaptation
to its environment. In this spirit, CAC is one of the most beautiful business models I have
come across as it is so perfectly adapted to its environment.
I am not arguing CAC is the greatest business model I have ever come across - it is for
sure no Coca-Cola - but it is the most perfectly adapted. I realise that lending businesses
are not everyone’s cup of tea. I realise that subprime lending businesses are definitely
not everyone’s cup of tea. But I recommend everyone who is passionate about
businesses to study CAC. It is a fascinating specimen.
On Cash
The fund has been more or less fully invested since the end of 2013. As markets are
higher today than at any other time since the inception of the fund and the fund has
periodically held substantial cash holdings, I thought it was high time to provide an
update (a more critical observer might say correction) on my thinking on cash.
Over time I have become increasingly sceptical on the merits of holding cash, at least for
a fund such as Business Owner which is small, concentrated and has an investor base
which is long-term and loyal.
I changed my mind when analysing Novo Nordisk in Autumn 2013. At the time I felt that
Novo had the ability to raise its earnings by 10% or more p.a., whilst at the same time
returning roughly 5% of its market capitalisation in cash to its shareholders through a
mixture of dividends and share buybacks. In a market that was for sure anything but
cheap, this nonetheless implied a 15% annual return to the long-term owner.
Leaving aside whether this investment thesis is right or wrong, which in any case we will
only know in a few years’ time, it is worth considering how this type of opportunity
stacks up against a strategy of periodically holding cash.
At a 15% return, a holding doubles in value roughly every 5 years. If we assume that in
a particular severe crash such as 2009 (though by no means the worst case scenario),
the markets fall by around 50%, the breakeven for holding cash vs. holding a Novo
Nordisk is, of course, 5 years. If 2009 type events happen more frequently than 5 years,
one would be better off periodically holding cash. If they are less frequent, one would be
better off being fully invested through the cycle. For posterity: interest rates are
currently 0% giving no return on cash over a five year holding period.
The question then becomes how frequent is a 2009 type crash likely to be over an
investing lifetime? Or put differently, was 2009 a five year storm, a ten year storm or
even a twenty year storm?
My strong sense is that it was at least a ten year storm and quite possibly a twenty year
storm. I had certainly never experienced anything quite like it and nor had others who
are significantly older than me. Warren Buffett put up a slide at the 2009 Berkshire
Hathaway shareholder meeting showing a treasury bill (effectively cash) trading at more
than 100 cents on the Dollar. He put it to his investors that they were unlikely ever to
see such a thing again in their lifetimes.
6
This being the case, I feel increasingly certain that holding great companies through the
cycle is the superior strategy, much though the thought of having cash in a 2009 type
scenario appeals to me.
I would like to emphasise that these deliberations should not be confused with some kind
of a forecast about what the equity markets are going to do over the next couple of
years. My sole interest is in doing the right thing over an investing lifetime, which I hope
will be many decades to come.
When a manager decreases his cash allocation, investors may be tempted to check up
over the next couple of years whether equity markets went up or down. As it happens in
the months following my decision the markets were at times substantially down though
the fund is up by roughly a quarter. However, this most likely tells us absolutely nothing.
We will only know in a few decades time what the storm frequency was and even then it
will have at best limited value looking forward.
I should add that these deliberations are specific to my situation. If I were running a
diversified fund (which necessitated finding hundreds of Novos) or if I were running a
high turnover fund (which necessitated finding hundreds of Novos…every month) or if I
had an investor base that was likely to run for the exit at the first signs of panic, I would
most likely run the fund differently.
Thankfully, it is not the case. I count myself as fortunate to have an investor base that
understands the importance of concentrating capital in your best ideas, does not equate
trading activity with industry, and in the various market wobbles of the last 6 years
including most recently last October has given me cash rather than asked for it.
On changing your mind
The most productive field for the study of finance over recent decades has been
behavourial economics. The field was pioneered by Kahneman and Tversky and I had the
great fortune to hear Kahneman speak at Zurich University in 2013. Their findings have
debunked the idea of homo economicus, Man as a perfectly rational being, forever
weighing up alternatives under the cold calculus of advantage and disadvantage. Instead,
Man turns out to be wildly irrational, forever torn by mental biases to decisions which, in
the cold light of day, are firmly against his interest.
One bias they identified is consistency bias – the unwillingness to move away from a
previously held opinion in the face of disconfirming information. It is easy to imagine that
this bias is extenuated by penning that opinion in a letter and, not only that, making that
letter public. You might legitimately ask whether writing this letter potentially damages
future returns. Put differently, would I distance myself from Credit Acceptance or any
other idea if confronted with disconfirming information?
I read Walter Isaacson’s excellent biography on Einstein over the summer and learnt an
important lesson in this respect.
What struck me about Einstein was his willingness to change his mind. He felt no loyalty
to a previous held position, no embarrassment about changing his mind, and as far as I
can judge he would not even consider his previous opinion a mistake provided it was
consistent with what was known at the time.
Seen through an early 21st century lens where intellectual consistency (sometimes
termed purity) is valued above all else, it is a sobering lesson. After invading Iraq on the
hypothesis that Iraq held weapons of mass destruction and subsequently not finding any
7
evidence to prove it, can you imagine Bush or any other leader changing their mind and
withdrawing his troops? No, me neither.
Einstein’s ability to change his mind was demonstrated most spectacularly with regards
to nuclear weapons. Einstein described himself as a “militant pacifist”. He believed in
unilateral disarmament and lent his name to many peace movements. And yet, he coauthored a letter to Roosevelt in 1939 encouraging the Administration to develop a
Uranium based bomb before Germany beat it to it. His letter led directly to the
Manhattan Project.
Consider the irony that the world’s most famous pacifist was also perhaps the sole
person capable of catalysing the US effort to develop the bomb and thereby potentially
change the outcome of World War II. He, uniquely, was sufficiently international to
understand scientific progress both in Germany and the US, sufficiently Jewish to
viscerally grasp the unique threat posed by Nazi Germany, sufficiently versed in physics
to foresee the implications of the progress in nuclear fission, and sufficiently famous to
gain the ear of the US president. No wonder he came to believe God does not play dice.
If the planet’s most famous pacifist can be persuaded of the merit of nuclear weapons,
then I hope it is within me to sell Credit Acceptance or any other company should one
day the facts call for it.
Investor meeting
Our investor meeting will take place this year on Saturday, 20 June 2015 in Bad
Godesberg. Bring the family. As with last year, there will be a program for children
including a trip to the Haribo factory outlet.
Yours sincerely
Robert Vinall
Kilchberg, 30 January 2015
8
Year
2008 (3 months)
2009
2010
2011
2012
2013
2014
Compounded Annual Gain 2008 - 2014
Overall Gain Sep 2008 – 2014
Annual % Change
in Business Owner
(1)
-13.4%
31.1%
27.0%
6.5%
18.4%
31.9%
24.9%
19.2%
199.6%
Annual % Change
in the DAX
(2)
-17.5%
23.8%
16.1%
-14.7%
29.1%
25.5%
2.7%
8.7%
68.2%
Relative Results
(1-2)
4.1%
7.3%
10.9%
21.2%
-10.7%
6.4%
22.2%
10.5%
131.4%
A Great Year
Dear Co-Investor,
The NAV of Business Owner was EUR 299.61 as of 30 December 2014. The increase in
NAV was 24.9% since the start of the year and 199.6% since inception on 30 September
2008. The Dax was up 2.7% and 68.2% respectively.
The best way to track the development of the fund is to follow the earnings performance
of the underlying investments, not the year-to-year change in the fund price. I will report
on how our companies got on in my half-yearly letter.
New investors can expect a rigorous and dispassionate interrogation of the companies’
performance. More seasoned investors can expect a one-sided laudation with all the
balance of an Oscar nomination viewed through rose tinted spectacles. What can I say? I
am an unapologetic fan of our companies.
One new investment
In the second half, I added one new company to the portfolio: the US-based Credit
Acceptance Corporation (“CAC”).
I am frequently asked how I come across new ideas. One way is through a network of
like-minded investors. In this particular case, Matthias Riechert, an emerging manager
based in London, pointed out CAC to me. Thank you, Matthias.
When I invest in a company, I like to be able to explain it to my children in a single
sentence. In this case, a single sentence might read: “CAC provides financing to
subprime borrowers for the purchase of a used car”. Whilst true, this does nothing to
capture the magic of the business.
So, in several sentences, where is the magic?
CAC does many things differently than traditional lenders. Most importantly in my view, it
requires the car dealer to participate in the risk of the consumer loan. Upon sale of the
car to the consumer, the dealer receives an upfront payment from CAC. Including the
down payment from the customer, the dealer earns a modest profit at the time the loan
is originated. CAC splits the collections on the loan with the dealer with the dealer’s share
of the collections first used to repay the amount received from CAC at loan origination.
After this amount has been repaid to CAC, the dealer continues to receive his share of
the collections which is called “dealer holdback”. As a result, to maximize the dealer’s
profit, the consumer must repay the loan.
1
At first glance, it makes little sense to require the dealer to co-underwrite a loan. How
can he know if a consumer is a good risk or not? However on closer inspection, it subtly
changes incentives. In so doing, it sets off a wonderful win-win situation for all three
parties concerned: the consumer, the dealer, and CAC.
The three main reasons a subprime borrower defaults on a loan are a) he cannot afford
it, b) the car breaks down (in which case he cannot get to work), or c) he loses his job.
The latter – unemployment – correlates closely with the economy and is beyond anyone’s
control. However, the dealer can influence the first two: by putting the consumer in a car
he can afford and by making sure the car is not a lemon.
Notice how this inverts the traditional role of the used car salesperson: to persuade the
consumer to trade up to something fancier and to get rid of his lowest quality inventory.
The approach creates a win for the customer as she gets a decent car she can afford, a
win for the dealer as he is able to make a sale he might otherwise miss out on, and a win
for CAC as it is able to generate profitable business with a customer other lenders are
unable to address economically.
There is also a win for CAC which goes beyond the purely financial. CAC is a purposedriven company. Don Foss, the Company’s founder, set up CAC based on his belief that
many people who need a car, but do not have access to traditional financing, deserve a
second chance. By extending financing to them, CAC gives them a chance to purchase a
car and rebuild their credit score by making timely payments. The Company’s motto is
“We change lives”.
Four criteria
How does CAC stack up against my four investment critiera: a business which will be
around and flourishing ten or more years; possesses competitive advantage; has a
management with integrity and talent; and an attractive price.
Credit Acceptance should be writing business 10 or more years from now
Demand for cars will remain strong across the US. There is a tendency in Europe to think
of the car as a luxury purchase as public transport represents a perfectly feasible
alternative. In the US, by contrast, the car is closer to a utility as outside of the major
cities it is simply impossible to fulfil the most basic needs without one. Given the
increasing polarisation of incomes, there is every reason to believe the subprime
segment (sadly) will outgrow the overall market.
Most importantly, CAC has the capital strength and the underwriting skill to ride the
various down cycles. It had an equity ratio of 31% at the end of 2013, which is multiples
of its competitors’. It also has a unique ability to underwrite risk. In each of the last 10
years (including the great recession), actual collections have generally been higher than
forecast collections and the worst result was a 3%-point negative variance (for the 2001
and 2007 vintages).
In an industry characterised by boom and bust cycles, CAC should be around and
flourishing in the long term.
CAC has a unique business model
Auto finance is not a business characterised by barriers to entry. Used car dealers are not
the most loyal bunch and will switch in a heartbeat to the highest bidder for one of its
loans. As such, CAC does not profit from barriers to entry in the classic sense. It does
profit from what Don Foss characterises as “barriers to success” or what I would term
competitive advantage. So what are its competitive advantages?
2
First, it has a unique expertise in underwriting and collections. This comes from many
sources, but in my view it benefits in particular from having been in the business far
longer than anyone else. This gives it the opportunity to continually refine its processes. I
visited the collections department and it is an impressive setup. Other more leveraged
players get wiped out at the end of each cycle leaving the way for a new crop of lenders
at the beginning of the next.
Second, it has a different approach to the market than most competitors. A big feature of
this is dealer participation in both the upside and the downside of its loans. As such, it
nurtures a partnership with the dealers rather than the typical customer/supplier
relationship between dealers and traditional lenders. Dealers self select who are keen
treat their customers fairly and change lives for the better. Those with a different agenda
leave the program as it does not work for them or do not start it in the first place.
CAC’s approach is difficult to replicate. It is nearly impossible for existing lenders to turn
their business models upside down. For new entrants, it takes a lot of time to build the
sales force, sign up and educate the dealers as well as develop the various other
processes and behaviours necessary to be successful.
Third, CAC has a unique culture, which is built around capital discipline and having fun.
CAC has no problem turning down unprofitable business. When it has surplus capital (as
is the case now) it simply redirects it towards buying back its own stock. There is no
pressure to write business. To get a sense of the culture, check out the video from its
40th birthday bash: https://www.youtube.com/watch?v=eZtWHGjfLYU. I had the good
fortune to visit the company on its birthday last year. It was great fun chomping on
hotdogs to Pharrell William’s “Happy”.
Management is talented and honest
There is a consensus amongst investors that it is tough to discern management quality.
Managers who reach the CEO position are necessarily great at selling themselves, they
contend, otherwise they would not reach their position in the first place.
For the most part, I agree. However, there is a small subset of managers it is not only
possible to evaluate; I would contend it is easy.
Don Foss, the Company’s founder, and Brett Roberts, its CEO, and several other of the
executives I met through my research process are part of that subset in my view.
Crucially, they have all been with the company for a very long time – in the case of Don
since the beginning in 1972 and in the case of Brett since 1991 (as CEO since 2002). One
can see how they reacted to crises (in the 1990s and more recently in the late 2000s),
whether they have communicated in an open and honest way with shareholders, and
whether they have delivered consistently outstanding results. On all these points, their
performance has been exemplary.
A case in point is a dispute between CAC and its auditor, as a result of which the 2005
annual report was delayed by nearly a year and the historical financials had to be
restated. When the new figures were published, it turned out CAC had understated
earnings over the previous 5 years by US$ 16.9 m. That is my kind of restatement!
To hear from Don Foss directly, watch this:
https://www.youtube.com/watch?v=wah9p824nYg.
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Valuation is attractive
At the time of purchase, CAC was trading at around 10x my estimate of 2014 EPS. This is
for sure a below average valuation for an above average business.
What should the long-term holder expect?
The company is highly opportunistic in allocating its capital. When pricing is attractive, as
was the case after the financial crisis, it aggressively expands its loan book. This leads to
returns in the high 20s / low 30s, assuming 100% capital retention and a return on
equity of around 30%. When pricing is less attractive, as is the case now, it aggressively
returns capital to shareholders. Last year, it repurchased 2.5 m shares, equal to just over
10% of its market capitalisation. As it bought the shares back below intrinsic value in my
view, the actual return to remaining shareholders was slightly higher.
Overall, it does not seem impossible that the annual return to the long-term holder
varies between 10% and 30% across the cycle.
Why is CAC so cheap?
Leaving aside the very real possibility that my analysis is faulty, there are at least three
potential reasons.
Firstly, CAC makes no effort to court investors. It does not attend capital market events
or undertake investor road shows. Management is focussed on the business and not
marketing to investors. As a major purchaser of its own shares, it has no interest in
inflating the share price. This does not mean though that it is indifferent to its investors.
Doug Busk and Jeff Soutar, who in addition to their day jobs get to field calls from
investors like myself, took considerable time over many calls to explain their business to
me with courtesy, intelligence and patience. I am hugely grateful to them both.
Second, CAC’s business is cyclical which makes it more difficult to value than, for
example, Novo Nordisk. It faces at least two cycles: the economic cycle and the capital
cycle. The economic cycle impacts earnings as default rates rise in a downturn and fall in
an upturn. The capital cycle impacts earnings as pricing pressure increases when there is
too much capital around and decreases when the reverse is the case. To a certain extent,
the two cycles offset each other as when the economy is in the doldrums, capital tends to
be scarce, whereas when it is up, capital becomes more abundant.
This begs the question, where are we now in the cycle? The answer is probably in a
sweet spot. CAC still benefits from loans originated when pricing was higher whilst
default rates are most likely lower than initially expected given the improvement in the
economy. Analysts argue that earnings may come under pressure in the short term. They
are probably right. My mission though is to put our capital into companies which will be
significantly more valuable in ten years’ time, not gamble on quarterly earnings
surprises.
Third, there are concerns about potential regulatory interventions in the subprime space.
There are two main regulatory concerns: one is that a bubble is forming, risking a rerun
of the financial crisis, this time in car loans instead of housing loans. The other is that
subprime lenders are exploiting their customers. The former implies that pricing is too
low, whilst the latter implies it is too high. If both sides claim they are right, it will be
entertaining to see what the policy response is.
In my opinion, market pricing is frothy, i.e. too low from the perspective of the lenders.
That being the case, the market should right any imbalances over time. Should however
the regulator decide to sharpen industry standards, I would expect CAC to be a net
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beneficiary given the obvious benefits of its lending model to all parties, not least the
borrower.
Isn’t subprime risky?
I can imagine some of you had a sinking feeling upon reading the word “subprime”. For
many it is synonymous with irresponsible lending, overpaid bankers, and the financial
crisis. For this reason, I want to make a few general comments on subprime lending and
why I am in favour of it.
To the casual observer, the root cause of the financial crisis was lending to subprime
borrowers. This was not the case.
The root cause of the financial crisis was irresponsible lending to subprime borrowers.
To understand this point, here is some background: The idea took hold in the early
2000s that pools of loans which individually were low credit grade could collectively
become “AAA” through the magic of diversification. The chimera of a higher interest rate
without any risk proved intoxicating to investors the world over. Demand exploded, in
particular amongst highly leveraged financial institutions, which were not allowed to hold
“risky” assets, such as the shares of great companies.
To meet the growing demand, bankers and brokers were helpfully on hand to whip up
demand for loans. Many individuals gladly bought houses (or second houses) that in
hindsight (and probably with foresight) they could not afford. As the bubble inflated,
underwriting standards, i.e. the conditions necessary for a loan to be approved, slipped.
This led ultimately to “no doc” loans, where the borrower was not required to
substantiate what his or her purported assets and income were. They were also known as
“liar loans” for reasons I cannot possibly imagine. Needless to say, it all ended badly.
It is important to note that the problem was not subprime borrowers per se but
deteriorating underwriting standards, primarily in the housing market. Warren Buffett
has made the point that in the manufactured housing market (in which there was no
credit bubble), loans performed no worse than would be expected in a recession despite
the typical borrower being subprime. For that matter, the same is true for subprime auto
finance loans.
It would thus be morally wrong to restrict the flow of credit to the poorest sections of
society.
It would also be financially wrong. For companies with good underwriting ability,
subprime is by far the most profitable market segment as there is greater variance in
credit performance. A first class lender to prime borrowers will struggle to differentiate
itself from peers as most borrowers repay anyway. In subprime, the divergence can be
enormous given a) the higher number of defaults and b) negative selection (the belowaverage underwriter fishes in a pool of loans the above average underwriters decline).
Does CAC exploit the financial illiteracy of its customers?
One question I also asked myself prior to investing is whether consumers are paying an
indecent interest rate. I have no interest in investing in a payday lender which charges
1% per day, which leads to a mind boggling compounded annual rate.
It is not obvious what the average interest rate on a CAC’s consumer loans are. The
nominal rate is generally 20 – 22% APR. However, both the dealer and the consumer will
generally focus on the monthly payment, which is a function of the sale price of the car,
the number of monthly payments and the interest rate. The dealer I visited said that he
generally leaves the interest rate untouched, but moves the sales price down to get a
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deal that “works,” i.e. which the consumer can afford. As such, the nominal interest rate
perhaps overstates the economic one. Either way, for the lowest quality credits an
interest rate of around 20% seems high but not unreasonable.
A beautiful business
I started my discussion on CAC by describing it as having magic. I would like to finish on
that note. I can imagine a botanist walking through a rainforest would not be drawn to
the most conventionally beautiful creature, but the one with the most unusual adaptation
to its environment. In this spirit, CAC is one of the most beautiful business models I have
come across as it is so perfectly adapted to its environment.
I am not arguing CAC is the greatest business model I have ever come across - it is for
sure no Coca-Cola - but it is the most perfectly adapted. I realise that lending businesses
are not everyone’s cup of tea. I realise that subprime lending businesses are definitely
not everyone’s cup of tea. But I recommend everyone who is passionate about
businesses to study CAC. It is a fascinating specimen.
On Cash
The fund has been more or less fully invested since the end of 2013. As markets are
higher today than at any other time since the inception of the fund and the fund has
periodically held substantial cash holdings, I thought it was high time to provide an
update (a more critical observer might say correction) on my thinking on cash.
Over time I have become increasingly sceptical on the merits of holding cash, at least for
a fund such as Business Owner which is small, concentrated and has an investor base
which is long-term and loyal.
I changed my mind when analysing Novo Nordisk in Autumn 2013. At the time I felt that
Novo had the ability to raise its earnings by 10% or more p.a., whilst at the same time
returning roughly 5% of its market capitalisation in cash to its shareholders through a
mixture of dividends and share buybacks. In a market that was for sure anything but
cheap, this nonetheless implied a 15% annual return to the long-term owner.
Leaving aside whether this investment thesis is right or wrong, which in any case we will
only know in a few years’ time, it is worth considering how this type of opportunity
stacks up against a strategy of periodically holding cash.
At a 15% return, a holding doubles in value roughly every 5 years. If we assume that in
a particular severe crash such as 2009 (though by no means the worst case scenario),
the markets fall by around 50%, the breakeven for holding cash vs. holding a Novo
Nordisk is, of course, 5 years. If 2009 type events happen more frequently than 5 years,
one would be better off periodically holding cash. If they are less frequent, one would be
better off being fully invested through the cycle. For posterity: interest rates are
currently 0% giving no return on cash over a five year holding period.
The question then becomes how frequent is a 2009 type crash likely to be over an
investing lifetime? Or put differently, was 2009 a five year storm, a ten year storm or
even a twenty year storm?
My strong sense is that it was at least a ten year storm and quite possibly a twenty year
storm. I had certainly never experienced anything quite like it and nor had others who
are significantly older than me. Warren Buffett put up a slide at the 2009 Berkshire
Hathaway shareholder meeting showing a treasury bill (effectively cash) trading at more
than 100 cents on the Dollar. He put it to his investors that they were unlikely ever to
see such a thing again in their lifetimes.
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This being the case, I feel increasingly certain that holding great companies through the
cycle is the superior strategy, much though the thought of having cash in a 2009 type
scenario appeals to me.
I would like to emphasise that these deliberations should not be confused with some kind
of a forecast about what the equity markets are going to do over the next couple of
years. My sole interest is in doing the right thing over an investing lifetime, which I hope
will be many decades to come.
When a manager decreases his cash allocation, investors may be tempted to check up
over the next couple of years whether equity markets went up or down. As it happens in
the months following my decision the markets were at times substantially down though
the fund is up by roughly a quarter. However, this most likely tells us absolutely nothing.
We will only know in a few decades time what the storm frequency was and even then it
will have at best limited value looking forward.
I should add that these deliberations are specific to my situation. If I were running a
diversified fund (which necessitated finding hundreds of Novos) or if I were running a
high turnover fund (which necessitated finding hundreds of Novos…every month) or if I
had an investor base that was likely to run for the exit at the first signs of panic, I would
most likely run the fund differently.
Thankfully, it is not the case. I count myself as fortunate to have an investor base that
understands the importance of concentrating capital in your best ideas, does not equate
trading activity with industry, and in the various market wobbles of the last 6 years
including most recently last October has given me cash rather than asked for it.
On changing your mind
The most productive field for the study of finance over recent decades has been
behavourial economics. The field was pioneered by Kahneman and Tversky and I had the
great fortune to hear Kahneman speak at Zurich University in 2013. Their findings have
debunked the idea of homo economicus, Man as a perfectly rational being, forever
weighing up alternatives under the cold calculus of advantage and disadvantage. Instead,
Man turns out to be wildly irrational, forever torn by mental biases to decisions which, in
the cold light of day, are firmly against his interest.
One bias they identified is consistency bias – the unwillingness to move away from a
previously held opinion in the face of disconfirming information. It is easy to imagine that
this bias is extenuated by penning that opinion in a letter and, not only that, making that
letter public. You might legitimately ask whether writing this letter potentially damages
future returns. Put differently, would I distance myself from Credit Acceptance or any
other idea if confronted with disconfirming information?
I read Walter Isaacson’s excellent biography on Einstein over the summer and learnt an
important lesson in this respect.
What struck me about Einstein was his willingness to change his mind. He felt no loyalty
to a previous held position, no embarrassment about changing his mind, and as far as I
can judge he would not even consider his previous opinion a mistake provided it was
consistent with what was known at the time.
Seen through an early 21st century lens where intellectual consistency (sometimes
termed purity) is valued above all else, it is a sobering lesson. After invading Iraq on the
hypothesis that Iraq held weapons of mass destruction and subsequently not finding any
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evidence to prove it, can you imagine Bush or any other leader changing their mind and
withdrawing his troops? No, me neither.
Einstein’s ability to change his mind was demonstrated most spectacularly with regards
to nuclear weapons. Einstein described himself as a “militant pacifist”. He believed in
unilateral disarmament and lent his name to many peace movements. And yet, he coauthored a letter to Roosevelt in 1939 encouraging the Administration to develop a
Uranium based bomb before Germany beat it to it. His letter led directly to the
Manhattan Project.
Consider the irony that the world’s most famous pacifist was also perhaps the sole
person capable of catalysing the US effort to develop the bomb and thereby potentially
change the outcome of World War II. He, uniquely, was sufficiently international to
understand scientific progress both in Germany and the US, sufficiently Jewish to
viscerally grasp the unique threat posed by Nazi Germany, sufficiently versed in physics
to foresee the implications of the progress in nuclear fission, and sufficiently famous to
gain the ear of the US president. No wonder he came to believe God does not play dice.
If the planet’s most famous pacifist can be persuaded of the merit of nuclear weapons,
then I hope it is within me to sell Credit Acceptance or any other company should one
day the facts call for it.
Investor meeting
Our investor meeting will take place this year on Saturday, 20 June 2015 in Bad
Godesberg. Bring the family. As with last year, there will be a program for children
including a trip to the Haribo factory outlet.
Yours sincerely
Robert Vinall
Kilchberg, 30 January 2015
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